Costs of Production Chapter 7

Explicit and Implicit Costs Economic Costs – payments a firm must make, or income it must provide, to resource suppliers to attract the resources away from alternative production opportunities Explicit and Implicit Costs Explicit costs – monetary payments a firm must make to an outsider to obtain a resource Implicit costs – monetary income a firm sacrifices when it uses a resource it owns rather than supplying it in the market Normal profits are an implicit cost. Economic profit = TR – (Explicit + Implicit)

Benji quit his job at Sweet and Sassy where he earned $60,000 per year Benji quit his job at Sweet and Sassy where he earned $60,000 per year. He sold $100,000 in US Treasury bonds that earned 5% interest annually to buy a food truck that specializes in a Vegan lunch menu. After a year in business Benji has averaged 100 customers per day (he only operates on weekdays, for 50 total weeks) who spend an average of $8 each. $5 per customer covers the costs of his materials (ingredients) and maintenance on the truck. Insurance costs $3000 annually and he pays $200 for a license to operate a food truck. What are Benji’s total revenues? What are Benji’s explicit costs? What are Benji’s implicit costs? What is Benji’s accounting profit? What is Benji’s economic profit?

Short Run Production Relationships (short run = fixed plant) Total Product (TP) – total quantity produced Marginal Product (MP) – extra output produced when one additional unit of a resource is employed Average Product (AP) – TP per unit of a particular resource (e.g. TP / units of labor)

Law of Diminishing Returns (law of diminishing marginal product) Assumptions – fixed technology, equal quality of variable resources As successive units of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decrease.

Graphs – MP and AP; TP

Short Run Production Costs Fixed Costs – costs which do not vary with changes in output -examples: rent/mortgage, insurance -must be paid even if output is 0 -can not be avoided in the short run -industry with very high fixed costs - airlines

Variable Costs – costs which change with the level of output -examples: fuel, labor, materials -Initially, variable costs increase by decreasing amounts. Eventually, variable costs rise by increasing amounts (law of diminishing returns) Total Cost – sum of fixed and variable costs TC=TVC + TFC At zero output TC = TFC

Graph – TFC, TVC, and TC

Per Unit Costs (Average Costs) Average Fixed Cost – AFC=TFC/Q Average Variable Cost – AVC = TVC/Q AVC declines initially, reaches a minimum, then increases again U shaped curve reflects law of diminishing returns Average Total Cost – ATC = TC/Q or ATC = AFC + AVC

Marginal Cost – extra cost of producing one more unit of output MC is the mirror opposite of MP curve (MP max = MC min) MC intersects AVC and ATC at their minimum points There is no relationship between MC and AFC

Graph – AFC, AVC, ATC, MC

Long Run Production Costs All costs are variable in the long run The long run ATC curve shows the least ATC at which any output can be produced after the firm has had time to make all adjustments in its plant size . (also called the planning curve) The long run ATC curve is made up of all the points of tangency from the short run ATC curves

Graph – Long Run ATC

Economies and Diseconomies of Scale Economies of Scale – portion of the long run ATC where ATC declines as output expands (per unit costs are decreasing) - labor specialization - efficient use of capital -purchasing power Diseconomies of Scale – At some point expansion causes ATC to increase -executives far removed, non responsive management -workers care little about the firm

Graph – Minimum Efficient Scale In a given industry, how large does a firm need to be in order to reach minimum ATC?